Facebook Buys Instagram, Pays the Distraction Tax

Facebook just bought Instagram for $1 billion. The most aggressive estimate is that Instagram has 13 employees, so this is likely a record. And, weirdly, Facebook bought just days after Instagram raised a round from some major investors.

Which is convenient, because it gives us a good way to benchmark the premium Facebook paid. Investors thought Instagram was worth $500mm as a standalone business; Facebook thought it was worth $1bn as a Facebook-controlled company. Thus, it’s fair to say that the control premium for Facebook is the remaining $500mm. (One can make two small adjustments in opposite directions: Instagram’s engineers will be more effective at Facebook, since they’re working with a larger userbase, so Facebook gets some synergies there. But Instagram’s valuation is also based on the probability that a buyer will have to overpay, multiplied by the expected premium they’d pay. Realistically, this is a bigger swing than the engineer-productivity number, so Facebook’s premium is over half a billion dollars.)

Did Facebook overpay? As a financial buyer, they probably did. Even as a financial buyer that can plug Instagram into the broader Facebook offering, they did. But as a strategic buyer getting rid of a strategic threat, they didn’t: they gave away something less than 1% of their enterprise value in order to reduce to zero the probability that Instagram will somehow upend their business. It would be optimistic to claim that Instagram has a 10% chance of reducing Facebook’s value by 10%—but even with those numbers, the Instagram deal makes sense.

It might be disconcerting to Facebook’s shareholders to realize that the company will periodically have to be the high bidder in deals where the whole point is to minimize the damage done to Facebook. But <1% of market value is a cheap price to pay. How often do new companies seriously threaten Facebook? Since they got big enough to buy people off, the big new threats have been: Twitter, Pinterest, and perhaps some day Path. That’s less than one a year. A 1%-of-enterprise-value per year “tax” on Facebook, for being a market leader, isn’t so terrible.

And it has sub rosa benefits: it’s a good recruiting pipeline for the very best engineers. Facebook is unusually good at making acquisitions work. And the kind of people who start a company that seriously threatens Facebook are the kind of people who can also help Facebook seriously threaten Google.

We’ve always understood, in the abstract, that tech companies consistently face existential threats from startups. And as funding gets easier and startups get more popular, this will only get more common. But if you’d asked investors what kind of discount they’d apply to Facebook based on this, they’d come up with something much bigger than 1% of enterprise value per year. The fact that Facebook can overpay so little is great news.

(Meanwhile, Instagram’s CEO has a nice talk on how they scaled the company. And the NYTpoints out that they were able to raise funding—and thus, indirectly, get bought—due to lots of real-world, in-person networking. And a VC points out why raising funds and immediately selling is not a viable plan.)